Description

The company has sporadically shown an ability to generate cash flow and net income, but over time it has generated none of either and yet trades at at a stupendous valuation. As of September 2003, the accumulated deficit was -$656 million. Total cumulative pro forma net income since 1996, including the bubble, only amounted to $228 million. Subtracting stock-based compensation, cumulative net income over that 7 2/3 year period amounts to -$150 million.
PMCS is a well-respected player in the communications semiconductor industry, but does not appear to have a particular advantage over its competition. The company has received some good design-wins recently and has seen a pickup in revenues, but does not appear to be pulling away from the competition. Competing firms have also received their fair share of design wins and have seen a similar pickup in revenues recently.
Direct competitors in the communications semiconductor business include Agere Systems, Applied Micro Circuits Corporation, Broadcom, Exar Corporation, Conexant Systems, Marvell Technology Group, Multilink Technology Corporation, Silicon Image, Transwitch and Vitesse Semiconductor. Other semiconductor competitors that focus on multiple industries include: Agilent, Cypress Semiconductor, Intel, IBM, Infineon, Integrated Device Technology, Maxim Integrated Products, Motorola, Nortel Networks and Texas Instruments. According to the company, “these companies are concentrating an increasing amount of their substantial financial and other resources on the markets in which we participate.” As a result of this competition and the downturn in their business, the company has indicated that OEMs have become more price conscious recently and that the company is seeing more aggressive price competition from competitors.
Starting in 2001, the company has been engaged in a very large restructuring of its operating expenses. The company has cut its staff, reduced R&D spending, bought its way out of leases it no longer needed, retired debt and cut other overhead expenses. Employment is down approximately 40% from 2000 levels. The company expects to achieve annualized savings of approximately $68 million in cost of revenues and operating expenditures from the restructuring vs. 2001. While the company’s cost structure is lower than it was in 2001, there is a significant question as to whether the company can return to peak performance with so many fewer employees. The business acts in many ways as an R&D outsourcing arm for the OEMs and as such has little in the way of assets other than its employees’ ability to come up with new design wins. That being said, the company’s headcount is still higher than it was in 1999.
PMCS is a member of the S&P 500.
Despite its history of mediocre (at best) performance, the current valuation for the company is simply outrageous.
The table below shows the valuation of the company based on ltm, peak and analysts’ projected performance. The pro forma numbers were provided by the company and exclude all restructuring charges, inventory writedowns, goodwill amortization, facility consolidation expenses, P,P&E writedowns, impairment of goodwill and intangible assets, contract settlements, amortization of deferred stock compensation, merger related expenses, gains on sale of investments, writedowns of capitalization of software licenses, acquisitions of in-process R&D and various other items. All told, from 1996 – 2002, the company’s pro forma net income excludes nearly $800 million of GAAP expenses, which is more than 3x the cumulative total pro forma net income from 1996 – 2002. Nevertheless, the table below shows multiples using pro forma figures. In addition, the company has paid massive amounts of compensation in the form of options as shown in the table above. Analysts’ estimates do not subtract stock-based compensation. Keep in mind that after the company reached peak revenues last time, it was part of a communications building extravaganza that created huge excess capacity which is still being worked off nearly 3 years later. After the company’s revenues peaked in 2000, they plunged more than 50% in 2001 and another 33% in 2002.

Price /
ltm pro forma earnings -93.5x
ltm pro forma, less stock-based comp. -32.0x
peak pro forma earnings 21.4x
peak pro forma earn., less stock-based comp 31.3x
avg pro forma earnings 1996 - 9/30/03 128.8x
avg pro forma earnings 1996 - 9/30/03, less non-cash comp 195.5x
cumulative pro forma earnings, 1996 - 9/30/03 16.8x
cumulative pro forma earn., 1996 - 9/30/03, less stock comp. -25.5x
avg 04 estimate 171.6x
high 04 estimate 118.3x
avg 05 estimate 67.4x
high 05 estimate 53.2x

tang book value 19.7x

Enterprise value /
ltm revenue 15.3x
peak revenue 5.2x
04 revenue 11.8x
05 revenue 9.3x

Ltm ebit -99.6x
peak ebit 20.5x
04 ebit 113.0x
05 ebit 54.0x

ltm ebitda 840.9x
peak ebitda 12.6x

ltm ebitda - capex 241.1x
peak ebitda - capex 19.8x
peak ebitda - avg capex 14.6x


Based on historical stock-based compensation levels, it appears highly unlikely that the average and high earnings estimates for 2004 and the average earnings estimates for ‘05 would be positive if stock-based compensation were subtracted. In a demonstration of the necessity of granting these options in order to retain employees (and thus why it would make sense to count stock-based compensation in net income), in the first quarter of 2003 the company allowed employees to exchange 17 million way out-of-the-money options for new options with an average price of approximately $7.00 per share. As a further demonstration of the magnitude of the stock-based compensation given out by the company, it is interesting to note that of the $860 million in paid-in-capital on the balance sheet, just over $800 million was generated from option exercises.

To put the valuation in perspective, here’s how the company would have to perform in order to justify its current valuation: LTM revenues grow 50% per year for 5 years, the company produces EBITDA margins of 30% per year in each year and spends $40 million per year on capex, which is the historical average, the company issues no new shares over the 5 years and pays no taxes during this period. Under this scenario, the company’s revenue in year 3 would exceed year 2000 revenues by about 10%, would be nearly double peak revenues in year 4 and nearly triple in year 5. Assuming a terminal net margin of 20%, the year 5 net income would exceed the cumulative total pro forma net income for the company for the 7 years from 1996 to 2002, excluding the effects of stock-based compensation, by 50%. At a terminal multiple of 20x earnings and a discount rate of 15%, the company would be worth, on a DCF basis, approximately $21.00 per share.

I think it would be fair to put such a scenario in the ‘unlikely’ category.

Even the very bullish analysts agree that at the current price the stock is beyond any reasonable justification. They all have price targets of $11 per share (which coincidentally is also beyond any reasonable justification).

Given the performance the company must achieve, the company’s return on capital would have to be truly extraordinary. So what have they done with excess cash recently? They repurchased $100 million of 3.75% convertible subordinated notes, which are convertible at $42.43 per share, for 97% of par. They also spent approximately $100 million purchasing and reselling a building in order to terminate a long term lease. It’s hard to imagine they would make north of a single digit return on such a transaction. This combined with insider sales of 1.1 million shares in just the last 6 months shows that perhaps management isn’t quite as bullish as the street.

The entire semiconductor industry has been on a tear this year, moving up nearly 70% YTD. Despite the run, PMCS, with its 300% increase has far outpaced the herd and is now trading at about a 90% premium to its peer group based on 2004 EV/Sales.

According to a recent CIBC report, the semiconductor industry is trading at 5x and 4x 2004 and 2005 projected revenues vs. 11x and 9x for PMCS, 74x and 73x projected 2004 and 2005 eps vs. 191x and 136x for PMCS (CIBC estimates) and 5.4x book vs. 19x for PMCS.

The historical average EV/sales ratio for PMCS dating back to its IPO in 1991 and including the bubble years is about 2.9x.

Risks
1) In the past, the company has made a number of acquisitions and has indicated it plans to make more. Most of these were relatively small and turned out to be poor targets. Nevertheless, the only way I can foresee this company being properly valued is if they are able to pull off some very large acquisitions of good companies with their stock. This seems unlikely, but you never know.
2) The company has been cutting operating costs very rapidly since 2001. Though its cost structure still appears to be higher than it was in 1999 and at least part of 2000, the company’s restructuring efforts are ongoing. In particular, the company is using its balance sheet to lower costs by repurchasing debt and buying its way out of leases (not to mention its long practice of paying people with a large amount of options instead of just cash). While these may not provide a good return on capital, they will make it far easier for the company to show positive pro forma eps. The fact of the matter is that technology analysts and investors believe the balance sheet is of no use in valuing a company – only projected eps matters. By offloading expenses and by pro forma-ing out as many expenses as possible, the company has an ability to show pro forma eps well above the actual earnings power of the company. This may allow the stock price to continue exiting the stratosphere.
3) The entire semiconductor industry and the communications sector in particular seem to be coming off a severe trough after the overbuilding in 1999 – 2000. Expectations are for demand to grow over the near term. It is reasonable to expect to see revenues and earnings for PMCS grow fairly rapidly in the foreseeable future.
4) Results are nearly impossible to project in this industry. At the beginning of 2001, the company projected its revenues would be over $900 million and analysts projected $1.1 billion. Actual revenues were about $300 million. Though I haven’t seen the reports, analysts probably underestimated the company’s growth going into 1999 – 2000. Analysts could be underestimating the company’s potential growth over the next couple years.
5) PMCS has sizable NOLs (100% of which is offset by a valuation allowance on the balance sheet) and probably will not have to pay much in the way of taxes in coming years. If we were to assume, contrary to management’s position, that the company was likely to be massively profitable over the next few years and the valuation allowance should be taken away, the company would have $300 million in a deferred tax asset added to its book value. Even in this scenario, the company would be trading at more than 7x book value.

Note: my employer is currently short the shares of PMC-Sierra and will profit if the shares decline in value. The above is merely our opinion and should not be construed as investment advice.

Catalyst

Over time it should become abundantly clear that the company cannot earn its way into this valuation.